A.M. Special Report: Structural Changes in U.S. Banks' Financial Statements at Year-End 2005.

OLDWICK, N.J. -- The fourth quarter ended Dec. 31, 2005, capped off a potential year of transition for the U.S. banking industry, as some of the key industry indicators turned less favorable. Driven primarily by a prolonged flattened yield curve, and exacerbated by cyclical and competitive forces, the industry's balance sheet and income statement composition shifted accordingly to reflect more defensive characteristics. At the same time, however, there also were some non-defensive elements in the industry's aggregate asset mix toward high-risk, high-return credits to combat margin pressures, according to a special report published by A.M. Best Co.

The industry's assets continued their path of robust growth during the last quarter of 2005, while asset mix shifted more toward higher-yielding assets, namely loan assets and, in particular, real estate loans. The industry's assets grew 1.7% during the fourth quarter of 2005 as compared with the third quarter, and 7.6% over the same quarter in 2004. The largest growth was in short-term interbank placements (federal funds and reverse repurchase agreements grew by 14.3% vs. the same quarter in 2004), as a way for banks to earn short-term interest income without locking into a longer-term position in anticipation of rising rates. Following this category of assets, loans and leases also grew at a high rate (9.9% over the same period in 2004). U.S. banks' securities portfolios and consumer credit assets increased marginally by 1.8% and 1.9%, respectively, over the same period in 2004. As a percentage of average assets, both categories decreased by around 1 percentage point. Commercial and industrial (C&I) loans and real estate loans--in all major classes of residential, commercial real estate, and construction and land development--increased as a percentage of average assets.

Of the industry's aggregate loan composition, real estate loans registered the largest growth, especially construction and land development loans as well as commercial real estate (CRE) loans. Real estate loans increased 12.4%, while construction and development loans jumped 33.2% and CRE loans rose by 9.5%, as compared with the same period last year. As mentioned, the rotation into real estate assets was a way for U.S. banks to enhance yield in a flat yield curve environment. Annual yields on loan assets, real estate assets and C&I loans stood at 7.4%, 7.1% and 7.7%, respectively in 2005--all up from 2004 levels. In comparison, yields on securities averaged 3.9% in 2005. This trend leaves banks susceptible to the softening real estate market conditions through potential declines in earnings and impairment of assets. U.S. bank regulators have taken note of the increased levels of CRE exposure and issued in January 2006 new proposed interagency guidance on CRE concentrations in an effort to address the rising levels of exposure in the industry to this sector.

Consumer credit yields were high, at 8.2% in 2005, but did not increase significantly as a result of large credit card charge-offs in the fourth quarter. It is expected that U.S. banks will look to build up their credit card portfolios aggressively in 2006.

The liability structure of the industry at Dec. 31, 2005, continued the prior years' trend of increasing reliance on non-core deposits and short-term borrowings, while the industry's equity capital kept pace with asset growth. Core deposits as a percentage of average assets declined by half a percentage point, to 45.6% at Dec. 31, 2005, from 46.2% at Dec. 31, 2004. Noncore deposits, such as uninsured customer deposits, brokered deposits and trading accounts as a percentage of average assets, rose consistently in the past several years, offsetting the lower levels of core deposits. Bank borrowings such as federal funds and repurchase agreements also followed the past several years' trend of steadily increasing as a way of funding asset growth.

A.M. Best will continue to monitor the industry on a quarterly basis and gauge both the level and direction of any changes and their impact on the overall risk level in the industry.

Best's Banking Center provides online access to data, special reports, analytical methodologies and news on the U.S. banking industry. For a complete overview, please visit www.ambest.com/banks.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.